Dollar Crushes Commodities

The long-in-the-tooth commodities correction plunged to new lows this week.
Traders were disappointed the Fed didn't announce a new quantitative-easing
campaign, so they dumped the popular commodities with a vengeance. But realize
the primary driver of the recent commodities weakness is not the Fed, but a
strengthening US dollar. The coming commodities price action heavily depends
on its fortunes.

This strong interrelationship between commodities and the US dollar is perfectly
logical. Thanks to the United States' economic dominance over the past century
or so, commodities are generally priced in dollars globally. While they have
local-currency prices, the great majority of the time these are actually a
direct function of a commodity's global dollar price and that local currency's
exchange rate with the dollar.

As capital inflows bid the US dollar higher in the global marketplace, this
reserve currency strengthens. And the more highly valued it is, the fewer dollars
are necessary to buy a given unit of commodities. Thus futures traders around
the world have long been conditioned to sell commodities when the dollar's
price is rising. And the inverse is true for a weakening dollar, it ignites
universal commodities buying.

The recent commodities correction is not a fundamental prediction of a weakening
global economy as the financial media loves to claim, but the simple mechanical
result of a rallying US dollar. So speculators and investors interested in
commodities and the companies that produce them need to focus on the US dollar
for insights. Why is it rallying, how high will it likely go, and when will
it turn south again?

Answer these questions, and you will get a great idea of where commodities
are heading over the near term. But first, the strong inverse correlation between
commodities and the US dollar couldn't be clearer on the charts. The best proxies
for each are the Continuous
Commodity Index (CCI) and the US
Dollar Index (USDX). The whole commodities story in recent months is simply
the strengthening US dollar.

Since spring, the USDX has surged higher three separate times. I highlighted
these big dollar rallies in red. In May this flagship dollar index climbed
4.4% in just over 3 weeks, straddling September it blasted 7.9% higher in just
under 5 weeks, and in the past 7 weeks or so it has surged another 7.4% higher.
Realize these are huge moves for the world's reserve currency, which
usually moves at a glacial pace.

Note above that the entire commodities correction since late April
happened during these major dollar rallies! If you look at the sharply-falling
blue CCI line within those red dollar-surging zones, the overlap between all
three more than accounts for every bit of the past half year's commodities
weakness. Commodities have been struggling simply because the dollar has been
strengthening, full stop.

Back in late April, this flagship commodities index actually hit an all-time
high. The global commodities market was robust and investors were excited
about commodities' global supply-and-demand fundamentals. Then commodities
started correcting in May, which is healthy and expected within any ongoing
bull market. It was the 14th
correction of commodities' decade-old secular bull, no big deal at all.

Periodic corrections are essential to keeping sentiment balanced, which prolongs
the ultimate longevity of bull markets. So they are utterly inevitable. Still,
it is typically some external catalyst that sparks a particular correction
at a particular time. And in May it was the sharply-higher US dollar. Why did
the dollar start rallying then? As I wrote at the time, it was simply
oversold so a bear-market rally was due.

That rally to rebalance away excessive fear in the dollar didn't last long,
and the moment the USDX started grinding sideways again so did the CCI. This
was even true in early August, an extraordinarily-scary time in the US stock
markets. As you recall, Obama's profligacy forced the first-ever downgrade
of US Treasuries in this nation's history. Stock markets plunged while fear
rocketed up to its effective
ceiling.

Yet over that frightening 2-week span when the benchmark S&P 500 stock
index collapsed by 16.8%, the CCI only lost 5.3%. Commodities losses ran only
about a third as deep as the stock markets' because the dollar barely budged
despite the extreme fear. The USDX was only up 0.6% over that span, so there
was no currency catalyst to frighten futures traders into another wholesale
exodus from commodities.

For several reasons, those early-August lows looked like the bottom in the
commodities correction at the time. The CCI was down 10.7% by that point over
a 3.6-month span. The average CCI correction in the decade before that (excluding
the brutal stock panic) was 8.8% over 1.6 months. 11% was about as big as commodities
corrections got with the exception of that once-in-a-century stock panic.

In addition the CCI was very oversold by early August, trading at 0.968x its
200-day moving average. Normally when this slow-moving equally-weighted geometrically-averaged
index falls below its 200dma, it is a great buying opportunity. And if the
US dollar couldn't rally significantly despite early August's massive fear
spike, then what could possibly drive major dollar buying? That really should
have been the commodities correction's bottom, so we loaded up accordingly
on beaten-down commodities stocks in August.

But alas, the markets are a probabilities game and sometimes the least-likely
outcome still flares up to scuttle even great opportunities. The resilient
and fully-corrected-by-bull-to-date-standards CCI started plunging on a gigantic
US dollar rally in September. This unforeseen event was extremely unlikely
based on dollar sentiment and technicals heading into that month, but it happened
anyway.

Several drivers contributed to the USDX's anomalous strength. Chief among
them was weaker US stock markets. Ever since 2008's once-in-a-century stock
panic, the USDX has tended
to surge whenever the stock markets are weak enough to spawn meaningful
fear. Though this tendency curiously failed to work in early August's sharp
selloff for some reason, it is powerful and crucial to understand.

The most-important US economic report that month was released in early September,
when US jobs growth came in sharply lower than expected. Even though that was
an erroneous read subsequently revised away the following month, it ignited
widespread fears of a US recession. On top of this Europe was a mess as always,
its leaders inanely diddling while global investors exited troubled sovereign
debt.

The dollar's rally higher accelerated later in September on a non-news development.
Even though the Fed had been telegraphing for months that it wasn't going
to embark on another inflationary quantitative-easing campaign
anytime soon, currency traders were still relieved that the Fed didn't launch
one. So the dollar surged. This happened again near the Fed's early-November
meeting, and again this week.

While the steep commodities selloff straddling September was way overdone,
its cause was inarguably the surging US dollar. When weak stock markets, recession
fears, Europe worries, whatever, lead capital to flood into this safe-haven
reserve currency, commodities get hit. But the CCI plunging 14.8% on a 7.9%
USDX rally was very excessive, as the CCI hit hyper-oversold
levels not seen since the stock panic.

Of course the US stock markets were radically oversold too heading into October,
when the irrational US-recession fears founded upon a single bad data point peaked.
That month the S&P 500 rocketed 10.8% higher in its best month in two decades!
And look what happened to the US dollar as stock markets surged. Flight capital
hiding in this zero-yielding parking lot quickly exited, and the USDX plunged.

Commodities immediately started rallying sharply, and didn't stop until late
October when the USDX started powering higher again. What drove it that time?
More Europe fears. Just as Europe had finally scraped together a deal
to bail out overspending Greece, the socialist Greek Prime Minister dynamited
the entire package. So the euro collapsed that day. And since it accounts
for 58.6% of the USDX's weight, the dollar rocketed.

And naturally what happened to commodities? Again they were crushed, as the
strengthening dollar led to widespread futures selling. There was nothing wrong
with commodities' bullish fundamentals, as they take years to change.
The only reason commodities spiraled lower again was because the dollar was
strengthening. This rally continued throughout November, driven by a sad comedy
of European blunders explained in our current monthly newsletter.

By late November, the USDX regained its early-October high. Seriously overbought
both times, it looked like a double topping. Indeed the CCI stabilized and
started rallying again immediately heading into December. But an event transpired
this week that pushed the USDX a bit above its topping levels and hammered
the CCI lower still. The absurdity of this episode just blows my mind, I can
hardly believe it.

Ever since the Fed's last quantitative-easing campaign ended at the end
of June, the FOMC has been very clear in communicating that it wouldn't
monetize more Treasuries unless something very dire happened. The so-called
QE3 program has been off the table completely for the better part of a half
year! In fully 4 previous FOMC meetings since QE2 ended, including an emergency
one, the Fed has steadfastly said no QE3.

So this Tuesday during the FOMC's 5th post-QE2 policy meeting, for the umpteenth
time it again declared economic conditions were far too good to warrant a QE3.
Yet for reasons that utterly defy me, and I live and breathe the financial
markets all day long every day, currency and commodities traders were surprised by
this. Do they live under rocks? Where on earth have they been since the end
of June?

Even though there was absolutely zero reason to expect a new quantitative-easing
announcement, the US dollar was immediately bid sharply higher. And
starting out near highs already, this drove the breakout above its topping
range shown above. A stronger dollar along with less monetary inflation than
some apparently expected just crushed popular commodities including gold and
oil. It was a bloodbath.

Thus the flagship CCI plunged to fresh-new correction lows. Its total correction
extended from an already-outsized 18.3% in early October to 20.6% this week.
Having actively traded this commodities bull since its very beginning, to me
this looked and felt like a desperate capitulation. Plunging commodities were
driven to their most-oversold levels since the stock panic, which are clearly
unsustainable.

The key to this entire commodities correction continues to be the fortunes
of the US dollar. The world is not consuming less oil, nor producing more gold,
than it was back in April near that all-time CCI high. Global commodities demand
growth continues to outpace supply growth. The only material thing that changed
was the value of the US dollar in the global marketplace. Can this safe-haven
currency keep on rallying?

This next secular chart offers some insights into this critical question.
Running from 2001, it encompasses the entire secular commodities bull
and secular US-dollar bear. Commodities prices have been rising on balance,
and the US dollar falling on balance, for good fundamental reasons over this
long span. Secular trends rarely change, and only when fundamentals do a radical
turn-one-eight.

These inverse supply-and-demand-driven secular trends remained pretty steady
until the epic disruptions of 2008's wild stock panic. The most extreme fear
we will ever see in our lifetimes led to a deluge of capital fleeing the stock
markets and commodities to temporarily weather the storm in cash and Treasuries.
This drove the biggest and fastest USDX rally in history over such a short
span, the dollar rocketed 22.6% higher in just 4 months!

Back then, just like today, there were widespread fears about whether or not
the euro would survive. Believe it or not, they have flared up periodically
ever since this composite currency was born in January 1999. Yet the euro keeps
chugging along and Europe gradually gets more and more integrated. There was
even a full-blown euro
panic in the spring of 2010, yet the euro is alive and well and higher today.

Despite all the extreme-dollar-bullishness (and extreme-euro-bearishness)
hype in late 2008 and early 2009, the USDX couldn't continue higher once
its panic buying abated. Why? Because its fundamentals are utterly rotten!
The Fed continues to create vast new supplies of fiat US dollars out of thin
air every year, yet a world awash in depreciating dollars is demanding fewer
as it diversifies away from them.

Perpetually-higher dollar supplies coupled with waning global dollar demand
equals lower dollar prices, there is no other long-term economic outcome possible.
Sure, demand can spike from time to time as stock-market selloffs or Europe
fears drive temporary flight-capital rushes. But once the intense fear passes,
and it always does, the fundamentally-bearish US dollar continues to drift
sideways to lower. The Fed simply prints too many new dollars for global demand
to ever keep up with.

Since that epic fear-driven dollar spike during the stock panic, the US dollar
has largely been grinding along sideways. This sorry consolidation isn't much
above the USDX's all-time low carved in April 2008. If the dollar is as fundamentally
bullish as traders argue today, why on earth hasn't it gained an inch of ground
since the stock panic? Because the supply-and-demand fundamentals of this rapidly-inflating
currency are still bearish!

In contrast consider commodities. The panic's dollar rally drove a brutal
46.7% plummeting of the CCI, utterly unprecedented. Bearish analysts came out
of the woodwork, including many commodities stars prominent today, utterly
certain the secular commodities bull was over. Just look at the charts,
they reasoned. The technical damage was so apocalyptic that there was no way
the commodities bull could be anything but dead.

But the legions of commodities naysayers then were dead wrong, the secular
commodities bull resumed immediately after the excessive fear started abating
in early 2009. The CCI extended its old pre-panic ways of powering higher on
balance with little interruption, blasting to new all-time highs in
late 2010 and early 2011. And the weaker the dollar was, the faster commodities
surged. Just like in the old pre-panic days.

How could commodities continue rallying so dramatically after being nearly
cut in half? Simple, their underlying global supply-and-demand fundamentals remained
bullish. We live in an industrializing world where billions of people are
working tirelessly to raise their families' standards of living. This ups consumption
and hence commodities demand, and there is no way scarce supplies can keep
up.

Regarding the state of commodities and the dollar today, there are really
only two questions to consider. Will global dollar demand, even after this
latest Europe scare inevitably fades, continue to grow faster than the Fed's
endless supply growth? Remember that the world is drowning in dollars, and
central banks have spent a decade trying to diversify away from their
depreciating dollar-dominated portfolios.

And will worldwide commodities supplies suddenly miraculously start growing
so fast that they outpace voracious global demand for the first time in a decade?
I think the most logical answer in both cases is no. The Fed will continue
to create endless new dollars out of thin air, increasingly necessary to monetize
Obama's unprecedented national-debt growth, far faster than the rest of the
world will want to buy this paper.

And hard-working Asians, Americans, and even Europeans are not going to stop
striving to increase their families' standards of living simply because Europe's
bloated socialist governments are too large to sustain. Even after a decade
of relentlessly-rallying prices, the world still cannot produce enough commodities
to fully offset the surging global demand. The dollar is bearish, commodities
are bullish.

Even from a pure short-term technical and sentimental perspective, the USDX
and CCI are due for an imminent and violent turn. The dollar is overbought
today by its own bear-to-date standards, while commodities are wildly oversold
by their own bull-to-date ones. Sentiment is nearly euphoric on the dollar,
and nearly terrified on commodities. Traders expect the currency to soar forever
while commodities keep plunging.

If you have even a single contrarian bone in your body, you have to love this
setup! When everyone thinks something is heading higher indefinitely, that
means the top is in and its rally is over. When everyone thinks something is
going to spiral lower forever, there is no clearer sign the bottom is in and
a major rally is due. The smart contrarian play is to short the overbought
currency and buy the oversold raw materials, without any doubt.

At Zeal we've been doing this over the past decade, with great success. If
you want to buy low, you have to be brave when others are afraid. Only
when fear reigns, when everyone is convinced prices are never going to rally,
are the best bargains found. Our track record earned from buying fear is outstanding.
Since 2001, all 591 stock
trades recommended in our subscription newsletters have averaged annualized
realized gains of +51%!

You actually have an amazing opportunity today thanks to this latest CCI plunge.
We added our latest commodities-stock positions, companies with amazing fundamental
prospects, back in August when the CCI looked to be bottoming. They
got dragged much lower in the subsequent selloffs. But this doesn't bother
us, as they will likely soar to big profits after the USDX and CCI inevitably
turn. Right now you can buy many of our existing trades at incredible bargains.
What a great way to prepare for 2012!

We publish acclaimed weekly and monthly subscription
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The bottom line is commodities have been crushed by the surging US dollar.
This sharp dollar rally, amplified by unsustainable Europe fears, is the sole
reason this latest commodities correction has been so long and deep. But this
doesn't change the underlying fundamentals for the raw materials or the currency,
which remain bullish and bearish respectively. Thus a sharp reversal is inevitable.

Just like after the stock panic, speculators and investors smart enough and
brave enough to buy commodities and commodities stocks when few others dare
are likely to earn fortunes. Once the dollar starts sliding again, which will
be exacerbated by rallying stock markets, commodities ought to be off to the
races given how extremely oversold they've been. Opportunities of this magnitude
are quite rare.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
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